Are living wills really the answer to banks that are too big to fail?

PROFESSIONAL negotiators recommend against making empty threats. Yet sometimes it seems that is all governments and regulators have left to throw at the banking industry. However bloodcurdling the political rhetoric, financial markets think banks will be bailed out again. That in turn means banks can borrow abnormally cheaply, giving them an incentive to maximise leverage and risk-taking again. Along with wrecked public finances and unemployment, moral hazard is the most toxic legacy of the credit crisis.

There is almost unanimous support for one set of remedies: making banks safer through bigger capital buffers and more intrusive supervision. Those wary of regulation's efficacy, however, should be pleased that the debate is now shifting to another tack—making credible the threat that next time, banks will be allowed to fail. Hence the voguish idea of “living wills”, or more amusingly, financial “death panels”, which would force banks and regulators to organise themselves so that it is easier to dismember systemically important firms in a crisis. That should minimise the cost to taxpayers of future bank failures. And if investors fear they could lose money tomorrow, they may penalise badly run banks today. Proposed laws will make it possible to kill any financial firm in a way “that imposes losses on firms' stakeholders”, Tim Geithner, America's treasury secretary, promised Congress last month.

It sounds good. But for living wills to have this effect, they must move beyond mere contingency planning and towards a partial break-up of banks' balance-sheets. And it is far from clear that this is what the G20 leaders intended when they endorsed the idea last month.

Living wills could certainly help address the sheer bedlam that surrounds a dying bank. In America the Federal Deposit Insurance Corporation (FDIC) already has powers to wind down some banks, but its remit did not include America's largest banks, nor non-bank monsters such as American International Group (AIG), an insurance company. Lehman Brothers had 2,985 legal entities, and in the panic before its collapse it became abundantly clear that no one understood its counterparty relationships with the rest of Wall Street. Clients and creditors still have cash stranded in the failed firm as administrators in different countries pick over its bones. If living wills forced banks to simplify, allowing investors and administrators to get to grips with their inner workings quickly, failures might be less chaotic.

Yet it is a huge leap to imagine that living wills can resolve moral hazard. Improving the mechanics of an execution does not make the decision to put a big firm to death much easier. If it has other banks as its creditors and counterparties, its failure—controlled or otherwise—will damage their solvency and liquidity. The FDIC may have special powers but it only allowed one biggish dismemberment during the crisis, that of Washington Mutual. Its deposits were passed to JPMorgan Chase and its creditors thrown to the dogs. Even then the firm had just 2% of the system's assets and its failure was only permitted once it was clear that a blanket bail-out of Wall Street was likely.

Indeed, the whole idea of an “orderly failure” is a little fantastical. If a “death panel” seeks to unwind a bank it will induce, not prevent, panic among its counterparties and creditors. Sheila Bair, the boss of the FDIC, has said regulators should act as a bridge as firms are wound down. Yet the crisis showed that regulators can only offer blank cheques or no cheques at all to the biggest firms. AIG and Dexia, a Belgian bank, sucked up over $100 billion of “temporary liquidity” between them, at which point they had taxpayers by the throat.

Ringed fences and scrambled eggs

The logical solution to these problems is ringfencing. If banks were run as federations of self-contained units, it would be easier to swoop in and save some parts while allowing others to die. For a unit to be safe, though, it would have to have not just its own capital, but its own funding and minimal counterparty exposure to other bits of the group. Most banks hate the idea of having to unscramble eggs. Many use branch offices abroad, rather than full subsidiaries with their own balance-sheets. Their Byzantine legal structures owe as much to history and tax planning as safety and efficiency.

The easiest path would be to force banks to organise themselves into self-contained national subsidiaries, with local rules on capital, and restrictions on lending to other bits of the group. If drawn too tightly these rules could backfire, making it harder for businesses to trade with foreign customers and draining liquidity provided by Western banks to deposit-poor foreign subsidiaries in places like eastern Europe. There could be perverse results, too. One Swiss bank says it uses surplus international deposits to lend to Swiss customers. Ringfencing could make its domestic unit riskier. Yet a balance can be struck: HSBC is already organised with partially ringfenced country subsidiaries.

The trouble is that national subsidiaries do not really correspond to the bits of banks that most people want bailed out: the deposit-taking part. British taxpayers would be livid if they had to save the British bit of Barclays' investment bank. A living will for Barclays would ideally allow regulators to save its deposit-taking unit, while allowing Barclays Capital to fail.

Ringfencing deposits in anticipation of a bank failure would come close to a stealthy reimposition of Glass-Steagall, the 1933 American law which separated commercial and investment banking and was repealed in 1999. Yet if living wills are to be a serious tool to limit taxpayers' exposure and moral hazard, they must involve decisions about which bits of banking are worthy of a guarantee and the creation of structures to protect them. There is little point in writing a will that evades the question of who ends up with what.